Principles and Policies I: Macroeconomics Chapter 10: The Multiplier Model Macroeconomics, Maclachlan 11/1/04

Chapter 10 Learning Objectives You should be able to … Explain the difference between induced and autonomous expenditures. Show how the level of income is graphically determined in the multiplier model. Use the multiplier equation to determine equilibrium income. Explain how the multiplier process amplifies shifts in autonomous expenditures. Demonstrate how fiscal policy can eliminate recessionary and inflationary gaps. List six reasons why the multiplier model might be misleading. Macroeconomics, Maclachlan 11/1/04

The AS/AD Model When Prices Are Fixed Real output Price level Induced shift (Multiplier effects) Initial shift 20 AD AD P0 Aggregate supply ? Cumulative shift Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 The Circular Flow Macroeconomics, Maclachlan 11/1/04

The Aggregate Production Curve Real production Real income Aggregate production (production = income) B C A $4,000 $4,000 45º Potential income Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 Multipler Model Aggregate Production curve meets … Aggregate Expenditure = C + I + G + (X-M) Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 Building Aggregate Expenditure Function: Autonomous and Induced Expenditures Autonomous expenditures – expenditures that do not systematically vary with income. Induced expenditures – expenditures that change as income changes. Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 Building Aggregate Expenditure Function: The Marginal Propensity to Expend Marginal propensity to expend (mpe) – the ratio of the change in aggregate expenditures to a change in income. It is composed of the various relationships between the component of aggregate expenditures. Its value is greater than 0 and less than 1. It is the slope of the aggregate expenditure curve. Macroeconomics, Maclachlan 11/1/04

Expenditures Function Autonomous expenditures is the sum of the autonomous components of expenditures: AE0 = C0 + I0 + G0 + (X0 – M0) Induced expenditures is the sum of the induced components of expenditures. Macroeconomics, Maclachlan 11/1/04

Solving for Equilibrium Graphically Real income (in dollars) Real expenditures (AE) (in dollars) Aggregate production 14,000 12,000 Aggregate expenditures 10,000 AE = 5,000 + 0.5Y Equilibrium 7,000 5,000 AE0 = 5,000 4,000 10,000 14,000 Macroeconomics, Maclachlan 11/1/04

The Multiplier Equation Expenditures multiplier – a number that reveals how much income will change in response to a change in autonomous expenditures. Macroeconomics, Maclachlan 11/1/04

The Circular Flow Model and the Multiplier Process Not all of the flow of income is spent on domestic goods (the mpe < 1). This represents a leakage from the circular flow. Autonomous expenditures are injections into the circular flow. They offset the leakages. Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 The First Five Steps mpe = .4 mpe = .5 100 100 50 40 25 16 6.4 2.56 12.5 6.25 Multiplier = 1/(1-0.4) = 1.7 Multiplier = 1/(1-0.5) = 2 Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 An Upward Shift of AE Real expenditures Real income Aggregate production 1,052.5 AE1 $4,210 30 1,022.5 AE0 4,090 $4,090 $120 Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 An Downward Shift of AE Real expenditures Aggregate production AE0 1,412 $4,152 AE1 1,382 30 $4,062 4,062 $90 Real income Macroeconomics, Maclachlan 11/1/04

Fighting Recession: Expansionary Fiscal Policy Potential output Aggregate production AE0 AE1 E1 mpe = 0.67 Recessionary gap ∆G = $60 $1,000 $1,180 Real income AE1 = 333 + 0.67Y SAS LAS AD1 AD0 E2 AD1΄ $180 $60 $120 Initial expenditures increase Multiplier effect McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Fighting Inflation: Contractionary Fiscal Policy Potential output Aggregate production AE0 AE1 E2 mpe = 0.8 E1 Inflationary gap ∆G = $200 $4,000 $5,000 Real income AE1 = 800 + 0.8Y B A SAS LAS AD0 AD1 P1 P0 $1,000 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Limitations of Multiplier Model It’s incomplete: needs info on where economy starts and potential output. It over emphasizes shifts in AE. It assumes a fixed price level. It doesn’t consider expectations. It ignores possibility of desired shifts in AE. It ignores permanent income hypothesis. Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 Problem 10-1 The mpe is 0.8. Autonomous expenditures are $4,200. What is the equilibrium income in the economy? $21,000 Macroeconomics, Maclachlan 11/1/04

Macroeconomics, Maclachlan 11/1/04 Problem 10-4 mpe = .6 Multiplier = 2.5 A = 1,000 + 8,000 + 10, 000 + 1,000 = 20,000 Y = 50,000 Increase in A of 2,000 Y increases by 5,000 (or 10%) Unemployment decreases by 5 percentage points. mpe = .5 Multiplier = 2 Y= 40,000 Y increases by 4,000 (or 10%) Unemployment decreases by 5 percentage points. Macroeconomics, Maclachlan 11/1/04